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Andrew Coleman on how the Tax Working Group produced a report that anything but looks to 'The Future of Tax'

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By Andrew Coleman*

Rock stars are lucky because they are remembered for their best songs, not the worst things they do.

For politicians it is usually the other way around.

I hope Michael Cullen is remembered for the NZ Superannuation Fund. The Fund is a serious attempt to reduce the extent taxes will need to increase in the future to pay for retirement incomes (assuming these are not drastically cut). It partially places the government retirement system on a save-as-you-go basis which means it accumulates assets and takes advantage of the power of compound returns.

The main argument of the report is that New Zealand’s tax system is different from the rest of the world's because we don't have a capital gains tax or many environmental taxes. This is true, but it ignores the single biggest difference: social security taxes.

Social security taxes are paid on labour income but not on capital income like interest, rents, or dividends. Unlike almost all other OECD (rich) countries, New Zealand does not use social security taxes to fund retirement incomes (or have a compulsory saving scheme) – the average country collects 8% of GDP more tax than New Zealand from this source. This is an enormous difference, and it has two implications that the report glosses over. First, it means New Zealand has the third lowest taxes on labour income in the OECD – that’s right, working people pay low taxes. Secondly, by many measures New Zealand has some of the highest if not the highest taxes on capital incomes in the OECD.

Given these differences it is surprising that the main recommendations of the report are to increase taxes on capital incomes and reduce them on labour incomes. Why is this surprising? If you impose high taxes on capital and business incomes there is a lot of international evidence that you get less investment and less innovation and this reduces productivity growth and incomes - including labour incomes. New Zealand has low levels of business capital and low levels of productivity already and raising taxes on capital incomes when they are already very high seems like a questionable strategy. The TWG report hardly discusses this issue at all.

It is also surprising because standard tax theory and standard international practice suggests capital income should be taxed at lower rates than labour incomes. The TWG report repeatedly states that all incomes should be taxed at the same rate without mentioning that this idea was rejected 50 years ago by the Nobel prize winning economists James Mirrlees and Peter Diamond because it is not a very effective strategy.

It is not effective because if you tax capital incomes at high rates you lower investment and people end up with lower incomes than they otherwise would have had.

Scandinavian countries, amongst the most progressive in the world, deliberately tax capital incomes at lower rates than labour incomes. They raise revenue by imposing high taxes on people with high labour incomes. They do this because they fear high capital income taxes will lead to an outflow of capital and reduce everyone’s wages. Most other prosperous countries in the OECD also have lower taxes on capital incomes than labour incomes because they use social security taxes. The TWG report appears to believe the rest of the world (and tax theory) is wrong – but they scarcely discuss either issue.

One of the downsides of increasing taxes on capital incomes is that it will further reduce the ability of young people to use the power of compound interest to build wealth - unless it is through owner-occupied housing. Most countries in the world reject this idea as silly and allow saving placed in retirement income accounts like KiwiSaver to compound before they are taxed, which leads to a much larger saving total. The government decided this was a bad idea in 1989, when they rejected the “Exempt-Exempt Tax” regime for retirement income savings that is supported by economic theory and used by most countries in the world. (Under this system you don’t pay tax on any money you place in a retirement saving account when you earn it, the earnings accumulate without tax, but the whole sum is taxed when it is withdrawn.) It appears that harnessing the power of compound interest is good for the NZ Superannuation Fund but not for middle or higher income individuals – unless they invest in owner-occupied housing.

Standard economic theory suggests that if you tax the income from housing less than the income from other assets, you will drive up the demand for housing and increase its price. (This is one of the key advantages of an EET retirement scheme – it taxes the income from all assets held in retirement income account on the same basis as the as owner-occupied housing. This has the added benefit that owner-occupied housing can be exempt from a CGT without causing such large tax distortions.) The TWG apparently hopes that taxing owner-occupied houses more lightly than other classes of assets will not cause people to build and buy larger houses, and will not lead to artificially large housing prices. They also hope that a capital gains tax will not lead to higher rents.

Unfortunately there is precious little evidence in favour of any of these propositions. If they are wrong, the costs will fall on current and future generations of young people.

The TWG report – “The Future of Tax” has very little to say about one predictable aspect of the future – it ignores the rising cost of government superannuation, which will necessitate higher taxes on young people in the future.

It doesn’t debate whether young New Zealanders might be better off with a different social security system, one which reduces the taxes they pay but uses the money to purchase stakes in businesses. Economic theory suggests that such a strategy should reduce long run wealth inequality by increasing the wealth of low income people, but this is not discussed in any of their reports.

Why do they assume that a social security system first designed in the 1930s and modified in the 1970s is the ideal system for the 21st century?

Indeed, it is scarcely a document about the future of tax at all. Its chair was the associate minister of finance when the tax reforms of the 1980s were undertaken, and its lead economist was the chief economist of the IRD who advised him back then, Robin Oliver. Yes, Taxman and Robin.

What do you get if you call up Taxman and Robin to solve the tax problems of the future? – you get an attempt to relitigate the problems they didn’t solve last time (or the time before that, or the time before that), especially capital gains taxes.

Unfortunately, I have news for them.

They waited for the house price horse to bolt before doing anything about it. This is very good for Taxman and Robin’s generation of baby-boomers, which has already made its fortune from untaxed capital gains on residential property. It is not so good for younger people who might have to pay higher rents going forward.

And did Taxman and Robin argue that taxes should be raised on their own generation to reduce the future increase in taxes that will be needed to pay their own generation’s superannuation payments? No, they forgot that problem too, hiding behind the shelter of the terms of reference that instructed them not to raising the top marginal tax rate, one of the lowest in the world.

The funding of New Zealand Superannuation and the taxation of retirement savings may seem like small problems, but they are related to the biggest problem facing the world - how the burgeoning numbers of poor people in Africa and South Asia can develop without cooking the planet. No countries have developed without using more energy, and in the past this has meant coal, oil, or gas. Fortunately there is a potential solution to this problem– the savings of rich ageing countries in the OECD and East Asia can be recycled to the countries around the Indian Ocean to build large quantities of capital-intensive green (non-carbon) energy projects. Unfortunately, by staying with a tax-funded retirement income system that accumulates no capital and by further tilting the tax system to favour investments in owner-occupied housing, they are undermining New Zealand’s ability to participate in the solution to the biggest problem of our time.

You can see from these remarks that I don’t believe the TWG has delivered a report designed to address the future of tax. (And I haven't even started on the substandard analysis involved that argues that capital gains should be taxed without making an allowance for inflation because interest is taxed without making an allowance for inflation: suffice it to say that two wrongs do not make a right. Taxman and Robin seem obsessed with the idea that real interest income and should be taxed at rates considerably higher than statutory rates.)

The Tax Working Group has delivered a report that is essentially backward looking, that ignores a lot of standard economic theory and the experience of other countries.

It wishes to increase the incentive to invest in owner-occupied housing, without properly analysing the consequence of that choice.

It pretends a capital gains tax is the major issue in New Zealand while ignoring the biggest differences between our tax system and those in other countries, differences that mean we have unusually high taxes on capital incomes that may be harming productivity.

It talks about the need to combat environmental problems without reforming the tax system so that people will accumulate the capital equipment that will actually solve those problems.

It ignores the major intergenerational issues facing the country.

In short, it’s rather disappointing. Maybe we should celebrate the Cullen Fund and hope this becomes the Culled Report, without preventing a proper investigation of these issues.

Perhaps the next report on the future of tax will even be led by the young people who will actually live in the future and deal with its problems. After all, as Ralph Waldo Emerson pointed out nearly two centuries ago, you need young people to generate bold ideas because old people have a bad tendency to spend their time defending the bold ideas they had when they were young.

*Andrew Coleman is a senior lecturer in the economics department at the University of Otago. He's also a principal advisor and economics lecturer at Treasury.

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33 Comments

Yes it is fair and good not to overlook the innovative and positive measures any government introduces, as per the example in this article, and to which Kiwi Saver should be added. There is a huge amount of debate at present concerning our tax system which, in turn, to put it simply, concerns the government’s income. To digress a bit, this always seems to me be a fixation on collecting the cream from on top of the pail and ignoring the milk pouring through the holes in its rusty bottom. My point is, if we got some effective redress and control on the wastage that occurs hand over fist, at national and local government level then collecting more and more money from the good citizens of this good country might not then be so damn critical.

National were elected on that principle 10 years ago but couldn’t get much traction. Yes there is probably plenty of wastage, but not enough to make any significant tax or rates cuts. Most of the money does go to real costs like health, welfare, transport, education, etc. Most of those are run pretty efficiently.

The fact they couldn't make any headway arguably says more about the strength of the Wellington bureaucracy than how efficient it is. How's the super efficient NZTA coming along with that Light Rail study? You know, the super important transport project Auckland badly needs? It's only *checks watch* four months late!

Agreed. My only query is judging by his photo Andrew Coleman may be over 40 himself. I'm not convinced by the argument that elderly pale males (eg myself) are unable to treat the young (everyones future) equitably and/or generously.
Why did the committee members allow themselves to be co-opted? If the govt can rule out increasing top tax rate and taxes on selling the family home then the govt must think itself more expert than their chosen committee.

A breath of fresh air. Cullen never grew up to see the flaws of his inflationary Leninist policies. He just doesn't see they are designed to destroy the fabric of trust that is the very basis of a civilised society. They are designed to set one group against another by arbitrarily re-allocating wealth. They do this in a way that makes most people poorer but enriches a few.

The few are not those who make society richer and more productive by their ability to allocate capital most productively, but those who, by luck or good judgement. are able to game the system most effectively. This opens the door for a gang of thugs to put themselves forward as white knights saving the poor. Keynes pointed this out in 1919. Michael Cullen is a classic case of what Stalin called a "useful idiot".

My only issue with the article is the Cullen fund. I do not think it will be end up being a fund for the benefit of ordinary New Zealanders. It is more likely to get used as a fund for paying the pensions of government employees. As it grows it will just get too tempting for them to resist.

I have no problem with the fund being used to rebuild vital infrastructure in the event of a massive natural disaster; but to use that as a screen to ringfence it for public sector workers who are already comfortably paid compared to the private sector, especially on an average-hourly-rate, would be revolution-inducing.

Steven Joyce was sure their use of Eminemesque was 'pretty legal' too :P In all honesty, the report is proposing a definitive tax to be substantively paid by young people, who are on the receiving end of a housing crisis created by boomers who will now pay less tax on their pensions. Doesn't really touch the sides as far as inter-generational fairness is concerned.

You may be right about non-property gapital gains but it is very difficult to imagine property prices rising much faster than inflation - we are almost impossibly high already - a pack of card propped up by accommodation allowances, first time home buyer perks etc.

I am sure that price drops in property prices are all part of Coalition’s plan to ‘re-set’ everything lower so that on ‘Valuation’ day the Government potentially ‘makes’ on more on CGT through their under-valuation of property caused by all the uncertainty their policies are creating amongst New Zealand ‘working’ public.

It was rather obvious from the beginning that the TWG was going to produce a dog of a report. Yes, there were knee jerk responses from both sides. However, the points raised by Dr. Coleman are very serious indeed and need to be discussed and addressed. It was also short-sighted of the terms of reference that welfare was also not considered - accommodation supplement and working for families has a massive impact on tax for many NZers. Unfortunately, we now have a government that seems like it doesn't know what to do with the recommendations and seems paralyzed. Well, Jacidna needs to make a captain's call and make this year of delivery - bin the report!

Given these differences it is surprising that the main recommendations of the report are to increase taxes on capital incomes and reduce them on labour incomes. Why is this surprising? If you impose high taxes on capital and business incomes there is a lot of international evidence that you get less investment and less innovation and this reduces productivity growth and incomes - including labour incomes.

Hang on...why add the business income tax component in there?

The point is rather than keeping incomes from labour bearing a disproportionate share of the load and having all money pour into housing, NZ needs to spread the load more (ideally to a Land Tax, but that's harder to get past certain cohorts than a CGT) while reducing tax on business and personal income so it makes more sense to invest in productive enterprise than just buy another rental for tax-free capital gains.

We also may not have compulsory retirement savings accounts, but it's nigh on there...certainly very highly recommended and likely taken up by the vast majority of working professionals (because they can foresee the super situation getting worse too by the time it's their turn).

... also , when in power , Sir Micky slagged off at previous tax reports and treasury recommendations as " ideological burps " ...

Now , his own tax report is so muddled and complicated that he has to hang around at $ 1062 / day to explain it to everyone ... the bits of it that he himself thinks he comprehends ...

... other heads of tax working groups have the good grace to plonk the finished report onto the finance minister's desk ... and to quietly clear off ... not Sir Micky ... hanging around , milking it for all he's worth , and taking the occasional pot-shot at Simon Bridges and the Gnats ...

@Jimbo Jones: I think you may have misunderstood what Coleman means by lifting taxes on Kiwisaver funds. Coleman's proposal I think is to stop taxing interest, dividends and cap gains in Kiwisaver funds that buy and sell shares. This could indeed help young savers grow retirement savings/wealth faster (putting aside a Nikkei 1989-peak-then-40%-down-30-years-later event in share markets).

Boomers who have owned shares in Kiwisaver since its inception will have paid taxes each year, slowing their rate of compounding. Lifting tax on Kiwisaver funds (and other forms of capital) would benefit young savers (although not so many earn enough to save much) rather than older savers by letting younger savers' investments in productive capital compound more quickly.

That's one of the reasons why property remains an enticing investment from a tax point of view insofar as some of the costs of active maintenance are capitalized into appreciation of the property's capital value which thankfully isn't taxed each year (and those expenses reduce annual taxes on the rental's profits). If you do the math on a fixed initial investment to compare Kiwisaver funds to a rental property sold after 40 years with a cap gains tax imposed just at the end of the holding period, then you'll see that this annual taxation of Kiwisaver funds substantially slows compounding and wealth accumulation.

Pick an annual rate of return and assume it's the same for before-interest rental profit and for the Kiwisaver fund's dividends and interest. Then compare (i) selling the rental at the end of a 40-year holding period (granting that taxable profit rates are very low on a fully mortgaged property investment) versus (ii) Kiwisaver fund under the current tax rules that fully tax dividends and interest each and every year before reinvesting them. The rental property still enjoys some potential partial tax advantage even with a CGT (which i personally oppose) because of the frequency of taxation. The rental's annual profits are of course taxed each year.

Reducing NZ's high taxes on capital is a fundamental requirement to improve our productivity and future wealth. Bravo to Coleman for being one of the few economists to talk openly about this point in the context of NZ tax debates (even though all should know this well already but apparently don't or have forgotten). Good article.

Why tax Kiwisaver at any stage. It's an essential social measure to avert elder poverty and build a resilent nation.
It's also a wonderful chance to organise - where government is the referee but not involved as a player.
No need for government subsidy, and why should the government clip the ticket with tax.
If everbody had a healthy KS balance, there is reduced on government, thus less need for tax.
So - universlal and compulsory ( it's poor people who need Kiwisaver most) no subsidies from taxpayers, no tax at any stage. I could accept that once your had the right awesome balance contributions become voluntary.

The left only really join the debate when there's money to distribute. That's your money & mine we're talking about. They are not the slightest bit interested in how to create wealth. As a young Helen Clark informed Roger Douglas all those many years ago now. ''I'm not interested in how they make the money, I'm only interested in how it's redistributed."

I am curious. this article makes similar claims MC did when in office, that we are one of the lowest taxed contries in the OECD. I always assumed this was in referrence to PAYE. My issue is that there are a lot of other taxes that are not accounted for, and during the dabate ll those years ago, someone whom I recall as being identified as an economic lecturer identified the average tax rate in NZ taking into account all taxes was in the vicinity of 47%. Can anyone validate this?

As an aside if it helps, when I ran the accounts for a company in the USA, I took a look at the payroll and added up all the outgo by both an employee and the employer contributions. This was federal and state tax and the respective, social security,health & unemployment & others that cannot exactly recall. Lumped together & averaged out that every dollar that flowed through the payroll generated over 60c of total take.

The author made some good points but pretty much lost credibility when he resorted to name calling. Taxman and Robin? At this point the article degrades into a whine about what the tax group didn't do.

"They waited for the house price horse to bolt before doing anything about it."

Right. You seem to have forgotten that the rider of that bolting horse was John Key and the National Party. Remind me again who was on National's TWG?